Rule 10b-5

What Is Rule 10b-5?

Rule 10b-5 is a regulation created under the Securities and Exchange Act of 1934 that targets securities fraud. This rule makes it illegal for anybody to directly or indirectly use any measure to defraud, make false statements, omit relevant information, or otherwise conduct business operations that would deceive another person in the process of conducting transactions involving stock and other securities.

Rule 10b-5 is formally known as the Employment of Manipulative and Deceptive Practices.

How Rule 10b-5 Works

Rule 10b-5 is the Securities and Exchange Commission's (SEC) main basis for investigating possible security fraud claims. Violations of the rule include executives making false statements in order to drive up share prices, a company hiding huge losses or low revenues with creative accounting practices, or actions taken to grant current shareholders a better return on their investments — as long as the deception remains undiscovered. These schemes typically require ongoing, misleading statements in order to perpetuate the fraud.

Rule 10b-5 also covers instances where an executive issues false statements in order to artificially drive down the price of a company’s stock so they can buy up more shares at a discounted rate. These and other manipulative uses of confidential information are acts of "insider trading."

In addition to making illicit profits and/or attracting more investors, these schemes are also put into motion as a way of taking over a company by changing the shareholder balance.

The Introduction of Rules 10b5-1 and 10b5-2

In 2000, the SEC further defined and clarified a range of issues related to potential securities fraud with their ratification of Rule 10b5-1 and Rule 10b5-2. These rules put insider trading into a more modern, legal perspective.

Rule 10b5-1

Rule 10b5-1 says that an individual is trading based on material nonpublic information (MNPI) if that person knows of said information while engaging in a sale or purchase of securities.

There are, however, exceptions and stipulations of Rule 10b5-1 that allow individuals to proceed with trading even if they possess such information. That includes trades that are parts of plans that were already set in motion through a contract or process that would not be affected by knowledge of the information.

According to Rule 10b5-2, securities fraud can be committed even under nonbusiness circumstances.

Rule 10b5-2

Rule 10b5-2 explains ways that the misappropriation theory — which postulates that a person who uses insider information in trading securities has committed securities fraud against the information source even if that person is not an insider — can apply even under nonbusiness circumstances.

It further states that an individual who obtains confidential information is obliged to a duty of trust.